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4 THEORETICAL FRAMEWORK OF THE STUDY


1.4.1 FINANCIAL STATEMENT ANALYSIS
1.4.1.1 INTRODUCTION
The massive amount of numbers in a company's financial statements can be
bewildering and intimidating to many investors. On the other hand, if you know how
to analyze them, the financial statements are a gold mine of information.
Financial statements are the medium by which a company discloses information
concerning its financial performance. Followers of fundamental analysis use the
quantitative information gleaned from financial statements to make investment
decisions. Before we jump into the specifics of the three most important financial
statements - income statements, balance sheets and cash flow statements - we will
briefly introduce each financial statement's specific function, along with where they
can be found.

The Balance Sheet


The balance sheet represents a record of companys asset, liabilities and

equity.
The Income Statement
The income statement, which reports on how much a firm earned in the period

of analysis.
The Statement of cash Flows
The statement of cash flows, which reports on cash inflows and outflows the
firm during the period of analysis

1.4.1.2 Meaning and Concept of Financial Analysis:34

The term financial analysis , also known as analysis and interpretation of financial
statements, refers to the process of determining financial strengths and weakness of
the firm by establishing strategic relationship between the items of the balance sheet,
profit and loss account and opposite data.
The purpose of financial analysis is to diagnose the information contained in financial
statements so as to judge the profitability and financial soundness of the firm. Just like
a doctor examines his patient by recording his body temperature, blood pressure, etc.
before making his conclusion regarding the illness and before giving his treatment, a
financial analyst analysis the financial statements with various tools of analysis before
commenting upon the financial health or weaknesses of an enterprise. The analysis
and interpretation of financial statements is essential to bring out the mystery behind
the figures in financial statements. Financial statements analysis is an attempt to
determine the significance and meaning of the financial statement data so that forecast
may be made of the future earnings, ability to pay interest and debt maturities (both
current and long-term) and profitability of a sound dividend policy.
The term financial statement analysis includes both analysis, and interpretation.
A distinction should, therefore, be made between the two terms. While the term
analysis is used to mean the simplification of financial data by methodical
classification of the data given in the financial statements, interpretation means,
explaining the meaning and significance of the data so simplified however, both
analysis and interpretation are interlinked and complimentary to each other Analysis
is useless without interpretation and interpretation without analysis is difficult or even
impossible most of the authors have used the term analysis only to cover the meaning
both analysis and interpretation as the objective of analysis is to study the relationship
between various items of financial statements by interpretation. We have also used the
terms Financial statement Analysis or simply Financial Analysis to cover the meaning
of both analysis is and interpretation.

1.4.1.3 Objective and Importance of Financial Statement Analysis:


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The primary objective of financial statements analysis is to understand and diagnose


the information contained in financial statement with a view to judge the profitability
financial soundness of the firm and to make forecast about future prospects of the
firm. The purposed of analysis depends upon the person interested in such analysis
and his object. However the following purposed or objectives of financial statements
analysis may be stated to bring out significance of such analysis.

To assess the earning capacity or profitability of the firm


To assess the operational efficiency and managerial effectiveness
To assess the short term as well as long term solvency of the firm
To identify the reasons for change in profitability and financial position of the

form
To make inter-firm comparisons
To make forecasts about future prospects of the firm
To assess the progress of the firm over a period of time

1.4.1.4 Types of Financial Analysis


According to modulus operandi analysis can be of two typesa. Horizontal analysis
b. Vertical analysis
a. Horizontal analysis-

If refers to the comparison of financial data of a company for several years. The
figures of this type analysis are presented horizontally over a number of columns. The
figures of the variously years are compared with standard or base year. A base year is
a year chosen as beginning point. It is also called Dynamic Analysis. This analysis
makes it possible to focus attention on items that have changed significantly during
the period under review. Comparative statements and trend percentages are two tools
employed in horizontal analysis.

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b. Vertical analysis-

It refers to the study of relationship of the various items in the financial statements of
one accounting period. In this type of analysis the figures from financial statements of
a year are compared with a base year selected from the same years statement. It is
also called Static Analysis. Common size financial statements and financial ratios
are the two tools employed in vertical analysis.

1.4.1.5 Methods or Devices of Financial AnalysisThe following methods of analysis are generally used:

Comparative statement
Trend analysis
Common size statements
Funds flow analysis
Cash flow analysis
Ratio analysis
Cost-volume-profit analysis

In this project the Ratio Analysis is used to study the financial statements of Britannia
industries.

Comparative Statement:-

The comparative financial statements are statements of the financial position at


different periods of time. The elements of financial position are shown in a
comparative statement provides an idea of financial position at two or more periods.
Generally two financial statements (balance sheet and income statement) are prepared
in comparative form of financial analysis.
The comparative statement may show1.
2.
3.
4.

Absolute figures (rupee amount)


Changes in absolute figures i.e. increase or decrease in absolute figures
Absolute data in terms of percentages
Increase or decrease in terms of percentage

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The Two Comparative statements are


1. Comparative balance sheet
2. Income statement

1. Comparative Balance Sheet

The comparative balance sheet analysis is the study of the trend of the same items,
group of items and computed items, group of items and computed items in two or
more balance sheets of the same business enterprise on different dates. The changes in
periodic balance sheet items reflect the conduct of a business. The changes can be
observed by comparison of the balance she at the beginning and at the end of a period
and these changes can help in forming an opinion about the progress of an enterprise.
The comparative balance sheet has two columns for the data of original balance sheet.
A third column is used to show this increase in figures. The fourth column may be
added for giving percentage of increases and decreases.

2. Comparative Income Statement

The income statement gives the results of the operation of a business. The
comparative income statement gives an idea of the progress of a business over a
period of time. The changes in absolute data in money values and percentages can be
determined it analyze the profitability of the business. .like comparative balance sheet
income statement also has four columns. First two columns give figures of various
items for two years. Third and fourth columns are used to show increase or decrease
in figures in absolute amounts and percentages respectively.

1.4.1.6 Advantages of financial statement analysis


The different advantages of financial statement analysis are listed below-

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The most important benefit if financial statement analysis is that it provides an


idea to the investors about deciding on investing their funds in a particular

company.
Another advantage of financial statement analysis is that regulatory authorities
like IASB can ensure the company following the required accounting

standards.
Financial statement analysis is helpful to the government agencies in

analyzing the taxation owed to the firm.


Above all, the company is able to analyze its own performance over a specific
time period.

1.4.1.7 Limitations of financial statement analysis

In spite of financial statement analysis being a highly useful tool, it also features some
limitations, including comparability of financial data and the need to look beyond
ratios. Although comparisons between two companies can provide valuable clues
about a companys financial health, alas, the differences between companies
accounting methods make it, sometimes, difficult to compare the data of the two.
Besides, many a times, sufficient data are on hand in the form of foot notes to the
financial statements so as to restate data to a comparable basis. Or else, the analyst
should remember the lack of data comparability before reaching any clear-cut
conclusion. However, even with this limitation, comparisons between the key ratios of
two companies along with industry averages often propose avenues for further
investigation.

1.4.2 RATIO ANALYSIS


Ratio Analysis is one of the most powerful tools of Financial Analysis. It is used as a
device to analyze and interpret the financial health of the enterprise. Ratios are
considered as one of the useful aids available to the Management in assessing the

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position and drawing conclusions regarding efficiency and financial status of a


Business Concern.

1.4.2.1 MEANING OF RATIO


A ratio is defined as the indicated quotient of two mathematical expressions and as
the relationship between two or more things.
An accounting figure conveys meaning when it is related to some other relevant
information. For example, a Rs.3000 crores Net Profit may look impressive, but the
firms performance can said to be good or bad only when the net profit figure is
related to the firms investment. The relationship between two accounting figures,
expressed mathematically is known as ratio.
According to Myers, Ratio analysis of financial statements is a study of relationship
among various financial factors in a business as disclosed by a single set of statements
and a study of trend of these factors as shown in a series of statements."
Ratio Analysis helps in summarizing large quantities of financial data and to make
qualitative judgment about the financial performance.
Ratio analysis is one of the techniques of financial analysis to evaluate the financial
condition and performance of a business concern. Simply, ratio means the comparison
of one figure to other relevant figure or figures

1.4.2.2 STANDARDS OF COMPARISON

The Ratio Analysis involves comparison for useful interpretation of the Financial
Statement. A single Ration in itself can not indicate favourable or unfavourable
condition. It should be compared with some standard. Standards of comparison are
of four types. They are
Trend Analysis: When ratios over a period of time are compared it is known as the
Time Series or Trend Analysis.
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Cross-Sectional Analysis: when ratios of one firm are compared with some selected
firms in the same industry at the same point in time, it is called as Cross Sectional
Analysis.
Industry Analysis: The ratios are compared with average ratios of the industry to
which the firm belongs; this sort of analysis is known as the Industry Analysis.
Pro Forma Analysis:

The comparison of current or past ratios with future ratios

which are developed from the projected or pro forma financial statements is called as
Pro Forma Analysis.

1.4.2.3 Significance of ratio analysis


Now the day analysis of financial statements has become of general interest various
parties are interested in the financial statements of a business due to various reasons.
By analyzing the financial statements each party can as retain whether his interest is
safe or not. The significance of the financial statements analysis for different parties
is as follow

Significance to management
The management can measure the effectiveness of the own polices and decisions,
determine the advisability of adopting new policies, procedures and document to
owners, the result of their managerial efforts.

Significance to investors
With the help of financial analysis investors and share holders of the business can
know about the earning capacity and the safety to their investments in the business.

Significance for creditors


Financial analysis tells them whether companies have sufficient assets and funds to
pay off its creditors.

Significance for government


Government can judge, the basis of analysis of financial statements, which industry is
progressing on the desired lines and which industry need the financial help.
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Significance to financial institution


With the help of financial statement analysis financial institution can know the profit
earning capacity of the business and its long term solvency.

Significance to employees
Analysis of financial statements helps the employees in determining the true profit of
the business enterprise.

1.4.2.4 Advantages and Uses of Ratio Analysis


There are various groups of people who are interested in analysis of financial position
of a company. They use the ratio analysis to work out a particular financial
characteristic of the company in which they are interested. Ratio analysis helps the
various groups in the following manner: 1.

To work out the profitability: Accounting ratio help to measure the


profitability of the business by calculating the various profitability ratios. It
helps the management to know about the earning capacity of the business
concern. In this way profitability ratios show the actual performance of the
business.

2.

To work out the solvency: With the help of solvency ratios, solvency of
the company can be measured. These ratios show the relationship between the
liabilities and assets. In case external liabilities are more than that of the assets
of the company, it shows the unsound position of the business. In this case the
business has to make it possible to repay its loans.

3.

Helpful in analysis of financial statement : Ratio analysis help the


outsiders just like creditors, shareholders, debenture-holders, bankers to know
about the profitability and ability of the company to pay them interest and
dividend etc.

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4.

Helpful in comparative analysis of the performance: With the


help of ratio analysis a company may have comparative study of its
performance to the previous years. In this way company comes to know about
its weak point and be able to improve them.

5.

To simplify the accounting information: Accounting ratios are very


useful as they briefly summarize the result of detailed and complicated
computations.

6.

To work out the operating efficiency: Ratio analysis helps to workout


the operating efficiency of the company with the help of various turnover
ratios. All turnover ratios are worked out to evaluate the performance of the
business in utilizing the resources.

1.4.2.5 Limitations of Ratio Analysis


In spite of many advantages, there are certain limitations of the ratio analysis
techniques and they should be kept in mind while using them in interpreting financial
statements. The following are the main limitations of accounting ratios:
1.

Limited Comparability: Different firms apply different accounting


policies. Therefore the ratio of one firm cannot always be compared with the
ratio of other firm. Some firms may value the closing stock on LIFO basis
while some other firms may value on FIFO basis. Similarly there may be
difference in providing depreciation of fixed assets or certain of provision for
doubtful debts etc.

2.

False Results: Accounting ratios are based on data drawn from accounting
records. In case that data is correct, then only the ratios will be correct. For
example, valuation of stock is based on very high price, the profits of the
concern will be inflated and it will indicate a wrong financial position. The
data therefore must be absolutely correct.

3.

Effect of Price Level Changes: Price level changes often make the
comparison of figures difficult over a period of time. Changes in price affect
the cost of production, sales and also the value of assets. Therefore, it is
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necessary to make proper adjustment for price-level changes before any


comparison.

Qualitative factors are ignored: Ratio analysis is a technique of

4.

quantitative analysis and thus, ignores qualitative factors, which may be


important in decision making. For example, average collection period may be
equal to standard credit period, but some debtors may be in the list of doubtful
debts, which is not disclosed by ratio analysis.

Effect of window-dressing: In order to cover up their bad financial

5.

position some companies resort to window dressing. They may record the
accounting data according to the convenience to show the financial position of
the company in a better way.

Misleading Results: In the absence of absolute data, the result may be

6.

misleading. For example, the gross profit of two firms is 25%. Whereas the
profit earned by one is just Rs. 5,000 and sales are Rs. 20,000 and profit
earned by the other one is Rs. 10,00,000 and sales are Rs. 40,00,000. Even the
profitability of the two firms is same but the magnitude of their business is
quite different.

1.4.2.6 TYPES OF RATIOS


Ratios are grouped in to various classes according to the financial activity or function
they evaluate. There are four important categories. They are

Liquidity Ratios
Turnover Ratios or Activity Ratios
Profitability Ratios

Liquidity Ratios measure the firms ability to meet current obligations; Leverage
Ratios measure the proportions of debt and equity in financing the firms assets;
Turnover Ratios reflect the firms efficiency in utilizing its assets, and Profitability
Ratios measure the overall performance and efficiency of the firm.

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I.

LIQUIDITY RATIOS

Liquidity Ratios measure the ability of the firm to meet its current obligations.
Liquidity Ratios establish relationship between cash and other current assets to
current obligations and provide a quick measure of liquidity position to the
management of the firm. Thus a firm should ensure that it does not suffer from lack
of liquidity and also at the same time see that it does not have excess liquidity.

A. CURRENT RATIO
The Current Ratio is a measure of the firms short term solvency. It indicates the
availability of current assets in rupees for every one rupee of current liability. A ratio
of greater than one means that the firm has more current assets than current liabilities
of the firm.
Current Assets include cash and those assets which can be converted into cash within
a year, such as marketable securities, debtors and inventories. Prepaid expenses are
also included in current assets as they represent the payments that will not be made by
the firm in the future.
Current Liabilities include creditors, bills payable, accrued expenses, short term bank
loan, income tax liability and long term debt maturing in the current year.
The Current Ratio is calculated by dividing the current assets by current liabilities:
Current Assets
Current Ratio =
Current Liabilities

B. QUICK RATIO
Quick Ratio establishes the relationship between quick or liquid assets and liabilities.
An asset is liquid if it can be converted into cash immediately or reasonably soon
without a loss of value.
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Cash is the most liquid asset. Other assets which are considered to be relatively liquid
and included in the quick assets are debtors and bills receivable and marketable
securities (temporary quoted investments).

Inventories are considered to be less

liquid.
Current Assets Inventories
Quick Ratio

=
Current Liabilities

C. NET CAPITAL RATIO WORKING


The difference between Current Assets and Current Liabilities excluding short term
bank borrowings is called Net Working Capital or Net Current Assets. Net Working
Capital is used as measure of firms liquidity capability. The Net Working Capital
Ratio measures the firms potential reservoir of funds. It is related to the Net Assets
or Capital Employed.

Net Working Capital Ratio =

Current assets Current liabilities

II. TURNOVER RATIOS


Turnover Ratios are employed to evaluate the efficiency with which the firm manages
and utilizes its assets. These ratios are called Turnover Ratios because they indicate
the speed with which assets are being converted or turned over into sales. These
ratios are also called as Activity Ratios. Thus Activity Ratios involve a relationship
between sales and assets. A proper balance between sales and assets generally reflects
that assets are managed well.
A. Net Assets Turnover Ratio
It indicates the relationship between Income from Services and the Net Assets and
how best the Net Assets are utilized by the company to generate revenue.
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Income from Services


Net Assets Turnover =

------------------------------Net Assets

Net Assets include Net Fixed Assets and Net Current Assets. Since Net Assets equal
Capital Employed, Net Assets Turnover Ratio is also called as Capital Employed
Turnover Ratio.
B. TOTAL ASSETS TURNOVER RATIO
The Total Assets Turnover Ratio shows the companys ability in generating sales from
all financial resources committed to total assets. Total Assets include Net Fixed
Assets and Current Assets.
Income from Services
Total Assets Turnover =

-------------------------------Total Assets

C. FIXED ASSETS TURNOVER RATIO


This ratio shows the firms ability in utilizing the Fixed Assets of the Company. The
ability of the company in generating income from the fixed assets can be known by
calculating this ratio.
Income from Services
Fixed Assets Turnover Ratio = -------------------------------Net Fixed Assets

III. Profitability Ratios


Profitability reflects the final result of business operations. There are two types of
profitability ratios: profit margins ratios and rate of return ratios. Profit margins ratios
show the relationship between profit and sales. The two popular profit margin ratios are:
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gross profit margin ratio and net profit margin ratio. Rate of return ratios select the
relationship between profit and investment the important rate of return measures are: return
on total assets, earning power, and return on equity.
Generally, there are two types of profitability ratios.

Profitability in relation to sales


Profitability in relation to investment

The profitability ratios are:


a. Gross profit ratio
b. Net profit ratio
c. operating profit ratio
d. Return on investment

A. Gross Profit ratio:


It is calculated by dividing the gross profit by sales.

Gross Profit
Gross Profit Ratio =

X 100
Sales

A firm should have reasonable gross margin to ensure adequate coverage for
operating expenses of the firm and sufficient return to the owners of business, which
is reflected in the net profit margin.

B. Net Profit ratio:


Net profit is obtained when operating expenses, interest and taxes are subtracted from
the gross profit. This ratio indicates the managements efficiency in manufacturing,
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administering and selling the products. This ratio is the overall measure of the firms
ability to turn each rupee into net profit.

Net profit after tax


Net Profit Ratio:

X 100
Sales

This ratio provides a good opportunity to compare a companys return on sales with
the performance of other companies. Thats why it is calculated after income tax
because tax and tax liabilities varying from company to company

C. Operating Profit Ratio:


It indicates profitability of entire business after meeting all operating cost including
direct and indirect cost of administrative and distribution expenses.

Operating Profit
Operating Profit Ratio

100

Sales

D. Return on investment
It measures the overall performance of the company that is utilization of total
resources and funds available with the company. Higher the ratio better utilization of
funds. It indicates earning capacity of the business. It measures the management
performance.

EBT But AT
Return on Investment:

X 100
Total Assets/ Liability
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IV. FINANCIAL LEVERAGE RATIOS

A. Debt Equity Ratio:


Higher the ratio less secured is the creditors, lower the ratio creditors enjoy higher
degree of safety.

Debt
Debt Equity Ratio:
Equity

B. Long Term Debt to Total Capitalization:


It explains the relationship between long term debts borrowed from outsiders with
owners contribution. Lower the ratio better is the solvency of the business and safer
is the creditor so far as his repayment.
Long Term Debt
Long Term Debt to Total Capitalization:
Total Capital Employed

V. DIVIDEND RATIOS
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A. Earnings per Share:


This ratio indicates weather over a given period their have been change in the wealth
per share holder. Other the ratio increases the possibility for the higher dividends and
increase in the market price of the shares.

Earnings after Tax Preference Dividend


Earnings per Share:
No. Of Shares Paid Up

B. Dividend Yield Ratio:


It indicates the ultimate current return which investor will get as a percentage of is
investment. It indicates the feature like the profitability and dividend policy of the
company. When dividend yield is lower than the expected return, market price for the
share may fall in future or vice versa.

Equity Dividend
Dividend per Share:
No. Of Equity Shares

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BIBLIOGRAPHY

1) Khan and jain, Financial Management, Tata McGraw-Hill Education, 5th edition,
2)
3)
4)
5)

2007.
http://www.readyratios.com/reference/analysis/financial_statement_analysis.html
http://www.slideshare.net/hemanthcrpatna/financial-statement-analysis
www.heterodrugs.com
www.wikipedia.org

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